Chapter Four: Testing the Notion of the Collaborative Print Studio

Fiscal policy means the use of taxation and public expenditure by the government for stabilization or growth. It refers to government actions affecting its receipts and expenditures which ordinarily taken as measured by the government‘s receipts, its surplus or deficit. The government may offset undesirable variations in private consumption and investment by compensatory variations of public expenditures and taxes. Arthur Smithies defines fiscal policy as ―a policy under which the government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment.‖ Though the ultimate aim of fiscal policy is the long-run stabilization of the economy, yet it can be achieved by moderating short-run economic fluctuations. In this context, it can be defined as ―changes in taxes and expenditures which aim at short-run goals of full employment and price-level stability. The following are the objectives of fiscal policy:

(i) To maintain and achieve full employment.

(ii) To stabilize the price level.

(iii) To stabilize the growth rate of the economy.

(iv) To maintain equilibrium in the balance of payments.

(v) To promote the economic development of underdeveloped countries.

An increase in public expenditure during depression adds to the aggregate demand for goods and services and leads to a large increase in income via the multiplier process; while a reduction in taxes has the effect of raising disposable income thereby increasing consumption and investment expenditure of the people. On the other hand, a reduction of public expenditure during inflation reduces aggregate demand, national income, employment, output and prices; while an increase in taxes tends to reduce disposable income and thereby reduces consumption and investment expenditures. Thus, the

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government can control deflationary and inflationary pressures in the economy by a judicious combination of expenditure and taxation programmes. For this, the government follows compensatory fiscal policy.

3.3.1 Compensatory Fiscal Policy

The compensatory fiscal policy aims at continuously compensating the economy against chronic tendencies towards inflation and deflation by manipulating public expenditures and taxes. It, therefore, necessitates the adoption of fiscal measures over the long-run rather than once-for-all measures at a point in time. When there are deflationary tendencies in the economy, the government will increase its expenditures through deficit budgeting and reduction in taxes. This is essential to compensate for the lack in private investment and to raise effective demand, employment, output and income within the economy.

On the other hand, when there are inflationary tendencies, the government reduces its expenditures by having a surplus budget and raising taxes in order to stabilize the economy at the full employment level.

The compensatory fiscal policy has two approaches vis: Built-in stabilizers and discretionary fiscal policy. The technique of built-in stabilizers involves the automatic adjustment of the expenditures and taxes in relation to cyclical upswings and downswings within the economy without deliberate action on the part of the government. Under this system, changes in the budget are automatic and hence this technique is also known as one of automatic stabilization. The various automatic stabilizers are corporate profits tax, income tax, excise taxes, old age survivors and unemployment insurance or relief payments. As instruments of automatic stabilization, taxes and expenditures are related to national income. Given an unchanged structure of tax rates, tax yields vary directly with movements in national income, while government expenditures vary inversely with variations in national income. In the downward phase of the business cycle when national income is declining, taxes which are based on a percentage of national income automatically decline, thereby reducing the tax yield. At the same time, government expenditures on unemployment relief and social security benefits automatically increase.

Thus, there would be an automatic budget deficit which would counteract deflationary tendencies. On the other hand, in the upward phase of the business cycle when national income is rising rapidly, the tax yield would automatically increase with the rise in tax rates. Simultaneously, government expenditures on unemployment relief and social security benefits automatically decline. These two forces would automatically create a budget surplus and thus inflationary tendencies would be controlled automatically. Built-in stabilizers have the following advantages as a fiscal device:

(i) The built-in stabilizers serve as a cushion for private purchasing power when it falls and lessen the hardships on the people during deflationary period.

(ii) They prevent national income and consumption spending from falling at a low level.

(iii) There are automatic budgetary changes in this device and the delay in taking administrative decisions is avoided.

(iv) Automatic stabilizers minimize the errors of wrong forecasting and timing of fiscal measures.

(v) They integrate short-run and long-run fiscal policies.

However, the limitations of built-in stabilizers include:

(i) The effectiveness of built-in stabilizers as an automatic compensatory device depends on the elasticity of tax receipt, the level of taxes and flexibility of public expenditures. The greater the elasticity of tax receipts, the greater will be the effectiveness of automatic stabilizers in controlling inflationary and deflationary tendencies. But the elasticity of tax receipts is not so high as to act as an automatic stabilizer in many countries.

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(ii) With low level of taxes even a high elasticity of tax receipts would not be very significant as an automatic stabilizer doing a downswing.

(iii) The built-in stabilizers do not consider the secondary effects of stabilizers on after-tax business incomes and of consumption spending on business expectations.

(iv) This device is silent about the stabilizing influence of local bodies, state governments and of the private sector economy.

(v) They cannot eliminate the business cycles but can reduce its severity at most.

(vi) Their effects during recovery from recession are unfavourable. Economists, therefore, suggest that built-in stabilizers should be supplemented by discretionary fiscal policy.

Discretionary fiscal policy requires deliberate change in the budget by such actions as changing tax rates or government expenditures or both. It may generally take three forms vis: changing taxes with government expenditure constant, changing government expenditure with taxes constant, and variations in both expenditures and tax simultaneously.

When taxes are reduced, while keeping government expenditure unchanged, they increase the disposable income of households and businesses. This increase private spending. But the amount of increase will depend on whom the taxes are cut, to what extent, and on whether the taxpayers regard the cut temporary or permanent. If the beneficiaries of tax cut are in the higher middle-income group, the aggregate demand will increase much. If they are businessmen with little incentive to invest, tax reductions are temporary. This policy will again be less effective. Thus, this is more effective in controlling inflation by raising taxes because high rates of taxation will reduce disposable income of individuals and businesses thereby curtailing aggregate demand.

The second method is more useful in controlling deflationary tendencies. When the government increases its expenditure on goods and services, keeping taxes constant, aggregate demand goes up by the full amount of the increase in government spending. On the hand, reducing government expenditure during inflation is not so effective because of high business expectations in the economy which are not likely to reduce aggregate demand.

The third method is more effective and superior to the other two methods in controlling inflationary and deflationary tendencies. To control inflation, taxes may be increased and government expenditure be raised to fight depression.

The limitations of discretionary fiscal policy include:

The discretionary fiscal policy depends upon proper timing and accurate forecasting. Accurate forecasting is essential to judge the stage of cycle through which the economy is passing. It is only then that appropriate fiscal action can be taken. Wrong forecasting may accentuate rather than moderate the cyclical swings. Economics is not an exact science in correct forecasting. As a result, fiscal action always follows after the turning points in the business cycles.

There are delays in proper timing of public spending. In fact, discretionary fiscal policy is subject to three-time lags vis:

(a) There is the ―decision lag,‖ the time required in studying the problem and taking the decision. The lag involved in this process may be too long.

(b) Once the decision is taken, is an ―execution lag.‖ It involves expenditure which is to be allocated for the execution of the programme. In a country like the USA it may take two years and less than a year in the U.K and more in a developing economy like Nigeria.

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(c) Certain public work projects are so cumbersome that it is not possible to accelerate or slow them down for the purpose of raising or reducing spending on them.

Despite the higher multiplier effect of government spending as against changes in tax rates, the latter can be operated more promptly than the former. Emphasis has thus shifted to taxation as the best fiscal device for controlling cyclical fluctuations. Thus, when the turning point of a business cycle is already underway, discretionary fiscal action tends to strengthen the built-in stabilizers which has been the experience of developed countries like the USA.

SELF ASSESSMENT EXERCISE

Write short note on taxation as a stabilization policy tool.